Diversifying assets to help manage risk

Strategic Asset Allocation provides a framework within which investors can target an expected return for a given level of risk. It is one of the most important, but one of the most overlooked aspects of wealth management. Strategic Asset Allocation ranks among the most important of investment decisions as studies show that it accounts for up to 90 per cent of long term investing returns.

Strategic Asset Allocation (SAA) is the process of allocating funds between asset classes to optimise investors’ return objectives and risk tolerance with long-run capital market expectations. The essence of SAA is diversification. Spreading investments across different types of assets can smooth out higher and lower return variations that occur through the economic cycle.

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Diversification

The essence of asset allocation is diversification. By spreading your investments across different types of securities you not only reduce the risk of your portfolio losing money; you also increase the chance that it will make money. Of course no matter what asset allocation you choose, there’s no way to eliminate risk entirely. Investing always involves the risk of loss.

One of the key principles of diversification is the 'risk-return trade-off'. Understanding the risk/return trade-off for the various asset sectors is very important. That is, the greater the returns, the greater the risk you take; and vice versa.

One of the most important decisions you will make is how much to allocate between the asset classes as your choice will fundamentally determine the long-term investment returns and fluctuations (volatility) of your portfolio.

Unfortunately, a dilemma every investor faces is that it is very difficult to predict future performances of each asset class. Therefore, diversification of your investment portfolio across all asset classes allows you to ‘hedge your bets’. By spreading your exposure and investing in different assets you create a portfolio in which you are able to minimise to some degree the losses that may occur in one asset sector with gains in another. The overall effect is that you moderate the volatility and ‘smooth out’ your investment returns over time.

The right mix

As a general rule, your allocation to shares should be higher if you plan to stay invested in those shares for an extended period of time. The reason for this is that the longer your time horizon, the more likely it is shares will outperform fixed interest. That said, even if you plan to be invested for many years, you must still be comfortable with the high risk level associated with a portfolio with a large allocation to shares.

Investors with a shorter time horizon should focus on cash and fixed interest, as holding shares for short periods is very risky. For example, while the long term return from shares is around 8 – 12pc, the return in any given year could be anything from minus 30pc to plus 50pc. However, the volatility of expected returns falls as the holding period increases, and the return over many years should be closer to the 8 – 12pc figure.

One very important factor in the asset allocation decision is whether you are near the end of your working life. As you approach retirement you should consider increasing your portfolio allocation to cash and fixed interest. The reason for this is that you can no longer count on salary income to sustain you should the share market have a period of negative returns. This is a case where you must distinguish between the risk level you are comfortable with, and the risk level you can actually live with if things go bad.